Wednesday, August 17, 2011

July producer prices rose more than expected, both at the core (0.4% vs. 0.2%) and total (0.2% vs. 0.1%) level. Producer price inflation has now been trending irregularly higher for almost 10 years, after trending irregularly lower throughout the 1990s. Over the past six months, the core PPI has increased at a 3.6% annualized rate, a level that was exceeded only once (in early 2008) in the past 20 years. Inflation is definitely alive and well.

These next two charts focus on the behavior of inflation and interest rates. Over long periods, inflation is the main determinant of interest rates, but over shorter intervals of as much as several years, interest rates and inflation can diverge, with interest rates tending to lag changes in inflation. Monetary policy is typically an important contributor to this divergence.

For example, currently the Fed is bent on keeping interest rates as low as possible, presumably in order to help stimulate the economy and to avoid the risk of deflation. The Fed's accommodative monetary policy stance can "fool" the bond market for awhile, especially since both the Fed and the bond market believe that inflation fundamentals have a lot to do with the strength or weakness of the economy. The economy is perceived to be so weak today that both the Fed and the bond market believe that even though inflation is rising, there is little risk that it will continue to do so.

But the divergence between interest rates and inflation can also serve to amplify the effects of monetary policy. When interest rates are substantially lower than inflation, as they are today (see third chart above), then investors, speculators, and corporations discover that it can be very profitable to borrow cheap money and buy "things" that are rising in price. Negative real interest rates thus encourage people to borrow more and more and speculate on rising prices, and the Fed is more than happy to accommodate this rise in the demand for borrowed money.

Just the opposite happened throughout most of the 1980s and 1990s. The Fed wanted inflation to fall, so it tightened monetary conditions by keeping interest rates high. Borrowing costs were much higher than the rate of return on the prices of "things," and over time this punished borrowers and eventually caused the demand for borrowed money to decline. Money gained new respect, and the demand for money increased. The dollar strengthened and commodity prices fell, and inflation proved to be low and relatively stable.

The confluence of forces today is much more reminiscent of the inflationary 1970s than of the low-inflation 80s and 90s. And it's quite simple in fact to determine whether inflation is likely to rise or to fall. All you need to know is whether the Fed wants to be accommodative or easy, and whether the Fed's professed policy stance is confirmed by real interest rates. Today there is almost no doubt that the Fed wants to be accommodative, and real interest rates confirm that, since they are substantially negative. Thus we can predict that inflation is likely to continue to trend higher in the next several years.

Borrowing money at today's exceptionally low interest is consequently likely to prove profitable. And as more and more people discover this, and the demand for money declines (increased demand for borrowing money is equivalent to a reduced demand to own money), then the dollar will tend to lose value and the prices of "things" will tend to rise. The gold market is well aware of that, and has likely priced in a lot of this already.

This is all very unfortunate, of course, since what is being fueled by all this is not a stronger or healthier economy, but a more speculative economy with higher inflation. A speculative economy is not a healthy economy, since speculation does not tend to produce productive things. Indeed, speculation leads to bubbles and the misallocation of resources, and over time this can be very inefficient and squander scarce resources. Thus it is that, instead of being "stimulative," the Fed's current monetary policy stance is acting to slow the economy's growth.

Meanwhile, the Bernanke Fed has put its reputation on the line by promising to keep short-term interest rates exceptionally low for at least the next two years. If the above analysis is correct, it won't be too long (another year?) before they are forced to change course and tighten policy, at great cost to their credibility and to the purchasing power of the dollar.

Why is it so hard for Washington to understand that the combination of easy money and fiscal spending stimulus is not at all a prescription for growth? A weak economy is the predictable outcome of easy money and too much spending. Instead of being even easier and more "stimulative," policy should emulate the combination that produced strong growth and a strong dollar in the 1980s and 1990s. Monetary policy should be focused on strengthening, not weakening the dollar. Fiscal policy should be focused on increasing the incentives for the private sector to work and invest and take risk—by lowering and flattening tax rates and eliminating tax preferences—not on spending more. Fiscal policy also needs to focus on radically reforming entitlement programs, which will otherwise grow like Topsy and skew incentives towards less work, less investment, and more idleness.

Actions by the Federal Reserve are increasingly irrelevant -- what we need to know is how and when gold-based currencies will appear on the open-market -- the constantly rising value of gold portends the end of the Federal Reserve (and dollar) as we know it...

It is true. Obama has been the greatest spender opf all and unemployment levels are up 50% since he arrived in office. The articial deficit stimulus only creates various financial bubbles and demand for 'cheaper' non domestic products. It has never worked anywhere. The end game is destructive inflation and the inevitaable collapse in living standards. If labor is truely 'cheap' then the jobs and manufacturing should follow. The highest corporate tax structure in the world effectively absorbs any increase in marginal profitability. There is no silver bullet - infortunately!

Oddly enough, Texas has been gaining jobs--but they are government jobs. The private sector has been contracting since 2008.

This from US News and World Report:

"Total jobs. Texas: Up 0.7 percent since the beginning of 2008. U.S: Down 5.6 percent. Since the recession began, Texas has added about 75,000 jobs, one of the few states with any job creation at all. Overall, the U.S. economy has lost about 5.6 million jobs since then.

But net job gains in Texas have come entirely from government hiring, which accounts for 115,000 new jobs over the past three years. The private sector in Texas shed about 40,000 jobs during that time.

Federal government jobs. Texas: Up 7 percent. U.S.: Up 4.3 percent. Nationwide, the federal government has been a steady source of job growth over the last three years, and Texas has gotten more than its share, thanks to several big Army bases and a heavy NASA presence. Texas is one of the biggest beneficiaries of Washington spending, which pumps more than $200 billion per year into the state economy, according to the New York Times. That reliance on federal money could backfire if there are cutbacks in military and space spending in coming years, as many analysts expect.

State government jobs. Texas: Up 8.4 percent. U.S.: Down 0.1 percent. While other states were furloughing workers, Austin was hiring. The prominence of the energy sector, which accounts for about 10 percent of the Texas economy, is one reason, since taxes paid by the booming oil and gas industry have generally drifted upward over the last decade."

It appears Texas is another pick state. Not red or blue, but a beneficiary of federal lard. Pink.

Hi Roller, the introduction of a new gold-backed currency (or similar commodities-backed paper) would be highly inflationary for real property and workers with certified skills (surgeons, skilled nurses, research scientists, etc.) -- however, the introduction of a gold-backed curency would also mean that Federal Reserve Notes would buy very little in the global markets -- in essence, Federal Reserve Notes would become a kind of local currency that is legal tender only within the US -- upon introduction of a gold-backed currency, commodities (e.g., oil, metals, ores, grains, etc.) would likely be priced in gold...

PS: I doubt the US will voluntarily introduce a gold-backed currency -- rather, foreign nations will take the lead and introduce the new currencies in an effort to remove the dollar as the world's reserve currency -- said another way, few in the US will be aware of the new gold-backed currency's introduction prior to the announcement of some foreign country or regional body -- the US would lose "big time" if a new gold-backed currency suddenly appeared on global markets.

This is a great post. Thank you. My first question: are you basically saying we are seeing the beginning of stagflation? Also, what investment vehicles would best take advantage of what you are describing?

Today's IBD article titled 'Dark Parallels: Not With Carter But With FDR' is a must read. Go to http://www.investors.com/NewsAndAnalysis/Article/581850/201108171839/Dark-Parallels-Not-With-Carter-But-With-FDR.htm

Considereing the above, it is clear Republicans have no interest in lower unemployment, though they won't admit it publically.

There may be Laffer-type curve for unemployment. Some optimum level, which, years ago may have been round 6 percent, where the benefits of competition for jobs exceeded the societal costs of unutilized labor. That level may have changed with greater globalization. Whether its higher or lower, I really don't know.